Morgan Stanley says earnings guidance is more unpredictable than ever, but focus on 'high-quality factors' can reveal long-term winners
- Morgan Stanley said investors should focus on "high-quality factors" as an effective trading strategy to overcome the uncertainty from companies dropping earnings guidance because of the pandemic.
- Only 8% of the companies in the small-cap Russell 2000 index still provide guidance, down from 21% a year ago.
- Although guidance plays a significant role in evaluating a company's future performance, Morgan Stanley said a better approach is to go long high-quality stocks that have beaten consensus earnings and revenue estimates.
- "The key for investors is having a trading strategy that separates true economic break-outs from technical noise," the bank's head of quantitative equity research said.
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Guidance on company earnings has become more unpredictable than ever, as the pandemic rages on, but focusing on "high-quality factors" can help reveal long-term winners, Morgan Stanley said.
About 74% of companies in the large-cap Russell 1000 index withdrew, or declined to provide, earnings guidance altogether in their quarterly reports this year.
Only 8% of the small-cap Russell 2000 still provide guidance, down from 21% a year ago, the bank said in a note on Wednesday.
Guidance attracts transient, short-term shareholders and plays a key role in investor analysis to evaluate future company performance and growth.
But in its absence, a superior approach is to explore "quality factors" that reflect the underlying health of a company, Morgan Stanley said.
The bank pointed out that during the 2008 financial crisis, investors unreasonably penalized those companies that disappointed in terms of revenue and earnings, and rewarded those that fell short on earnings but beat revenue expectations.
"The key for investors is having a trading strategy that separates true economic break-outs from technical noise," said Boris Lerner, Morgan Stanley's global head of quantitative equity research. "At the end of the day, it's all about the quality of earnings."
Lerner and his team found that an effective way to "find alpha in earnings surprises" is to go long high-quality stocks that have beat consensus earnings and revenue estimates, and short low-quality stocks that missed expectations.
"Quality factors" include metrics such as profitability, accruals, operational efficiency, leverage, and earnings stability, relative to the company's broader industry.
"Although revenue growth alone does not define a high-quality company, it is a strong indication that there is demand for its products or services," Lerner said.
A strategy that combines composite surprise and earnings quality is more rewarding for investors and demonstrates the potential for consistent performance, he highlighted.